The Role Of Internal Control And External Auditing In Inhibiting Earning Management

The Enron event has led to a series of domino effects. And since then, USA published famous Sarbanes-Oxley Act and other countries also begin to establish a series of internal control system rules and formulations. The "internal control storm" has swept all over the world. In China, Blue Sky fraud case, Green Earth fraud case, Sanlu incident, CAO and CNPC scandal got exposed successively, which makes us realize our capital market is insufficient and needs to be improved. From2006to2010, China’s regulators have issued and improved Guidelines for Application of Enterprise Internal Controls, Guidelines for Evaluation of Enterprise Internal Controls and Guidelines for Auditing of Enterprise Internal Controls. These norms and guidance signals the establishment of external supervision system on internal control, and has been improving and optimizing the internal control system greatly. Under this background this research is to make an empirical test about the effect of internal control and external audit on inhibiting earnings management.The internal control system of enterprises is designed to reduce the earnings management behavior, avoid the frequency of financial fraud. To improve its design and implement, most of countries have made efforts to strengthen the construction of enterprise internal control after a number of financial scandal shock. And auditing mechanism is similar to internal control mechanisms. Internal control, for inside supervision and external auditing mechanism, for outside supervision, interactively function to reduce the agency cost and the information asymmetry and ultimately improve the quality of the earnings, and inhibit the earnings management behavior. According to microeconomic theory, we find that internal control and external audit are substitutes. Because both of them have the same function, and can work independently to achieve consumer spending-inhibiting management opportunism behavior. There is a certain HOLD MALDEN phenomenon when customers consume Pepsi and Coca-Cola. The internal control realizes a comprehensive management. Compared with the external auditing, internal control has a certain advantage in collecting information (but compared with the management information, it is still at weak position). The external auditing emphasizes that auditors use professional knowledge to judge the accounting output for the business financial results to realize outside supervision. So there should be a certain substitution effect between the external auditing for "results supervision" and internal control for "process supervision". This paper, based on the theoretical derivation, is explore how the internal control and external auditing independently inhibit earnings management and whether there is a substitution effect on the earnings management behavior of listed companies. The results will richen the theoretical research in the earnings management field.Since the measuring model of real earnings management was introduced into China by Roychowdhury (2006), there is lack of domestic academic study to examine the earnings management mechanism from the two different perspectives. We are going to make a research about accrual and actual earnings management activities of the listed companies from the perspective of internal and external supervision. So this research conclusion will further enrich this field, and its special research perspectives will also provide an excellent empirical basis and guidance for the enterprises and the government.The research is innovative in the following aspects:(1) From the research views, this paper focuses on two ways of the earnings management, namely accrual earnings management and real activity earnings management, and further the study of earnings management.(2) From the research contents, this paper focuses on the issue whether there is any substitution effect between the external control and internal auditing on inhibiting earnings management. The lack of adequate research in this respect lead to the inconclusive understanding among the academics, and this paper will help to enrich empirical research on the subject.(3) From the research results, the conclusions fully verifies substitution effects between the internal control and external auditing, and further the study about how internal control and external auditing interact to guarantee the quality of financial information, and reduce earnings management behavior.(4) From the research sample selection and sample size, this paper samples the data of listed companies covering from2010to2012and gets2252effective samples after initial data processing, which is a great improvement compared with the past year of study.In this paper, the research questions can be summed up in these following aspects:(1) If the company has high-quality internal control system or high-quality external auditing supervision, whether the accrual earnings management and real earnings management behavior have been reduced.(2) The effect of the internal control mechanism on accrual earnings management and real earnings management is weaken or strengthened under different external auditing environment.In order to study those issues, this paper adopts normative and empirical research methods. The normative research parts are as follows:The literatures review chapter:This chapter reviews domestic and abroad research about internal control, external auditing and earnings management.The theoretical analysis chapter:This chapter analyses the three research variables, the internal control, external auditing and earnings management, and clarifies the relation among internal control, external auditing and earnings management, and provides theoretical bases to put forward hypothesis.The empirical research parts are as follows:The hypothesis and modeling chapter hypothetically establishes the logical relationship between three variables and sets up the research model.Hypothesis1:if internal control is high-quality, the possibility of companies to implement accrual and real earnings management activities is lower.Hypothesis2:if external auditing is high-quality, the possibility of companies to implement accrual and real earnings management activities is lower.Hypothesis3,4:there is substitution effect between internal control and external auditing on reducing accrual and real earnings management activities of corporates.Based on the hypothesizes above, this paper refers to the study of Pan Yue et al.(2009) and Zhang Dunli, Lee Sihai (2012)) to establish regression models.The variables selecting chapter:The theory analysis part provides a detailed argument to select BIG4and DIB index to be substitution variables of audit quality and internal control quality. But many scholars such as Yang DeMing et al.(2009), Fang HongXing et al.(2012), also choose the enterprise voluntary disclosure index to measure the quality of internal control. In order to achieve a robust and multi-angles study, we collect three indicators manually, including whether the enterprise issues internal control self-assessment report, hires external auditing for internal control evaluation and the internal control auditing report gets a standard opinion to form one index-TOTAL, as a substitution variable of the internal control. Referring to the previous studies, Accruals earnings management is measured by the modified Jones models, and real activity earnings management is measured by Roychowdhury (2006) and Cohen et al.(2008) models.The empirical testing chapter details the conclusions:(1) the internal control and external auditing function independently to reduce the earnings management.(2) There is a substitution effect between the internal control and external auditing. If the external auditing is low-quality, high-quality internal control, as a process supervision mechanism, has a stronger effect on reducing earnings management; if the external auditing is high-quality, internal control has a weaken effect on reducing earnings management as the realization of the internal control functions partly rely on the external auditing. In addition, sampled data shows that the internal control disclosure index (TOTAL) presents a rising, while DIB index does not. It implies the possibility of managing vaguely or neglecting regulatory actions in the listed companies in China. The listed companies cares to perfect the information disclosure of internal control but ignore the promotion of real internal control quality. Compared with the TOTAL, as a substitute for internal quality control variable, DIB index are less affected by the external law, and it can be more scientific and steady to measure the true quality of internal control.The final chapter puts forward some feasible suggestions how to better the quality of internal control and external auditing for the accounting firms, companies and Regulatory Authority.